Whittle down great pension expectations

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE — What happens when you combine a recession, an unwillingness to pay your way, and unrealistic expectations of how much you can make in the stock market?

For U.S. state employee retirement funds, the answer is you end up with an underfunding of $1.26 trillion, a shortfall that will cause political strife and personal misery.

That misery, however, may extend beyond those whose pensions and benefits are slashed or taxes raised, as the issue has at its heart a fundamental miscalculation that is also embedded in many company and personal retirement plans.

A study by the Pew Center on The States found the $1.26 trillion shortfall, which is split roughly evenly between a lack of money in state employee pension plans and un-funded retired employee future health benefits.

The shortfall, which is as of fiscal 2009, is a 26 percent increase on the year before. And lest you think it’s all caused by the recession, partial results for 16 states show an additional increase in the level of underfunding in fiscal 2010.

Public sector retirement funding is a failure with many fathers, including an unwillingness to tax to meet obligations, spiraling health care costs and, to be fair, an awful recession that slashed revenues and left many states even less willing to stash away the needed funds.

At its heart, the underfunding issue is substantially governed by the actuarial assumptions used to calculate how much the plans need to salt away every year to have enough to meet their promises.

Those actuarial assumptions, in turn, have embedded into them an assumption about how much investments will earn in future. The more money you expect to earn on your investments, the less you need to save. State funds generally use an 8.0 percent assumption, which seems high but is incredibly convenient if you are a state official and don’t want to (a) raise taxes and commit political suicide, or (b) slash benefits and commit political suicide.

That 8.0 percent may be highly optimistic. If the state plans used the the lower target of a high quality corporate bond yield, about 5.2 percent, as their investment target then the deficit balloons all the way out to $1.8 trillion.

Should you decide to be even more conservative and pencil in returns equal to 30-year Treasuries — about 4.3 percent — then the states face a collective $2.4 trillion shortfall.

POST-WAR ABERRATION

But why should we expect to earn 8.0 percent? In part, this is because pension investing developed during the post-World War II-era, a time when equities did much better than they should have based on dividend and earnings growth.

There are many who think that equity returns in the post war period were higher than could be explained by the fundamentals, and thus higher than what we should expect going forward.

Eugene Fama and Kenneth French found that the U.S. equity risk premium — the amount of extra return investors got for taking ownership risk – during 1951-2000 was far larger than you would expect looking at earnings and dividend growth.

It may be that this period was simply a good time for stocks — after all it included the rebuilding after the war and a period of dropping inflation. It may even reflect the build up of savings made by the baby boomers, so much of which was funneled into equities.

Generally equity returns are linked to the growth in earnings, which in turn is linked to the growth of the overall economy. It is hard to see strong reasons for economic growth to suddenly take off in the developed world. Nor should we expect an increase in the share of GDP that corporations are able to capture as earnings. After a blip during the recession that is back to levels that are close to an all-time high.

If we add into this demographically-driven selling, as retiring baby boomers begin to eat their savings, the outlook for a return to the 20th century glory days of stocks looks even more remote.

So, while equities, which are at the heart of pension savings, will likely beat other asset classes over the longer term, they may not beat them as soundly as they did in the past. That matters, a lot, because it will make even worse the underfunding.

So, how will this play out? Once the shortfall is so large it cannot be ignored, states will try and cut benefits, as they have in Wisconsin, while at the same time taking on ever more risk in hopes of out-earning their problems.

Look for the snake-oil salesmen to be on the spot offering private equity, structured products and hedge funds, all promising better than equity returns and all with high embedded costs to the investor.

The sooner we cut our expectations, the better.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

I like the reference to snake oil salesmen. Here in Geneva there’s been an insidious encroachment of hedge funds and derivatives in all types of managed accounts. In Arabia, where I do most of my work, there is a sickening level of oversold private equity. At some point people are going to wake up and realize these are just investment entry points with extremely high fees and commissions, and no long-term value for the investors. Thanks, Mr. Saft, for putting the snake oil salesmen on notice.